Should you put your money into the firms hoping to beat cancer? Biotech and healthcare funds race ahead this year - but investors should tread carefully

Biotech and healthcare funds are riding high among the top performers of 2014 as promising new drugs and robust consumer demand lure investors to the sector.

Exciting breakthrough cures for hepatitis C and perhaps even cancer have made headlines, but the healthcare industry is also seen as a dependable buy-and-hold investment due to worldwide demographic and wealth trends.

The idea is that the ageing populations of rich developed countries are bound to need more medical services and products in future, while at the same time growing numbers of people in emerging markets are becoming able to afford improved medical care.

Breakthrough: Biotechnology involves using living organisms or parts of them to make products such as pharmaceuticals

It's an attractive story at a time of unease about wider market prospects, particularly regarding 'cyclical' sectors which see their fortunes rise and fall with economic performance. Health-related businesses are considered 'defensive', meaning they can better withstand economic shocks.

The question for potential investors is whether sentiment will turn against the sector - particularly the biotech area of it, which involves using living organisms or parts of them to make products such as pharmaceuticals. Biotech companies might be dynamic but they are also notoriously risky and prone to upsets.

Investors should also bear in mind that although there are some big European players, the healthcare industry - again, particularly the biotech corner of it - is dominated by US giants. And US markets have hit record highs this year, prompting dire warnings that stocks have got way too expensive.

Moreover, US Federal Reserve boss Janet Yellen told a Senate hearing in July this year she thought the valuations of smaller biotech and social media firms 'appear substantially stretched'.

Her surprise intervention was likened to predecessor Alan Greenspan's warning about 'irrational exuberance' during a previous US stock boom - which as we all know now was headed for a crash.

That said, investor interest in the biotech and healthcare industry is intense right now, and could be spurred further if star fund manager Neil Woodford goes ahead with an as yet unconfirmed plan to launch a UK-focused life sciences investment trust in 2015.

Woodford's investing record is impressive enough that his main equity income fund has attracted a flood of cash since it launched this year and, while nurturing unlisted cutting-edge biotech firms would be very much a niche sideline by comparison, where he goes his legions of fans may be willing to follow.

To assess the outlook for the biotech and healthcare sector, we asked finance experts Anna Haugaard of Brewin Dolphin and Gavin Haynes of Whitechurch Securities to give their take on its recent success and offer fund and trust tips to those looking to invest.

New fund? Interest in the biotech sector could be spurred further if star fund manager Neil Woodford goes ahead with an as yet unconfirmed plan to launch a UK-focused life sciences investment trust

Why are biotech and healthcare stocks doing so well?

A cure for hepatitis C and the anticipated launch of 'immuno-oncology' drugs with the potential to cure cancer have got investors excited about the chances of big future returns.

Brewin Dolphin fund analyst Anna Haugaard says such drugs could make billions of dollars when they reach peak sales - despite likely controversy over how much companies will want to charge for them.

Biotech stocks took a temporary hit in April on concern that governments might try to force price cuts on Gilead, which developed the eight-pill course of treatment to cure hepatitis C.

But Haugaard suggests such worries have since faded, explaining: 'At end of the day, these drugs save the healthcare system money. With hepatitis C that's a liver transplant, multiple visits to specialist physicians, loss of productivity. It's hard to argue about pricing when the company has a cure.'

Meanwhile, US president Barack Obama's health reforms have proved a positive development for American hospitals, which are now more likely to get paid for treating people after seven million enrolled in insurance under the legislation this year.

Obamacare: US president's health reforms mean more Americans have insurance and hospitals are more likely to get paid for treating them

Another factor driving the healthcare sector of late has been mergers and acquisitions activity, even if the two big UK-focused ones - Pfizer-AstraZeneca and AbbVie-Shire - were mostly motivated by cutting US tax bills rather than any loftier ambition, and both deals ultimately fell through.

Gavin Haynes, managing director of Whitechurch Securities, believes investors have turned to the healthcare sector this year in search of stocks that can grow in a more difficult economic environment.

He says rather than being linked to short-term cyclical growth in the economy, healthcare has a long-term structural growth story and is viewed as a more defensive sector.

'In healthcare the long-term dynamics are very positive,' says Haynes. 'Worldwide the average age is increasing. As people get older they spend more money on medical products and services.'

But he also points to the rising wealth of people in emerging markets: 'As affluence increases so will their ability to afford improved medical care. China, Brazil and India have huge populations.

'Over the long term that means increased spending on healthcare and drugs and pharmaceuticals and medical devices. Potentially that offers great rewards for the companies offering these services.'

What should investors consider before taking the plunge?

The Nasdaq biotechnology index in the US is up 33 per cent so far in 2014 - far outperforming the MSCI World index which has risen just over 4 per cent in the same period.

Haugaard says that because the biotech sector as a whole has done very well, funds invested in those stocks have done so too. She therefore suggests investors look closely at whether managers' records are simply in line with or beating the overall market when choosing a fund.

'The sector itself has been extremely strong. When you see Axa Framlington up [see table below] that's not a lot of outperformance compared to the index. So managers should be outperforming the index.

'Over the longer term, it's important to have skilled fund managers in this sector. There are going to be winners and losers.

'Share picking is very important because there are some expensive biotech stocks and there are some very attractive ones as well.'

Haynes says healthcare is a major industry sector, so investors will get exposure to it if they are in UK and global funds anyway.

But he adds: 'It's such a niche area, it really requires knowledge of products and services that a generalist fund manager can't provide.'

He suggests investors who want to buy a specialist healthcare fund limit exposure to no more than 5 per cent of their portfolio, and be aware it will also give them significant weighting in the US stock market.

Meanwhile, he cautions that biotechnology remains only a small part of the overall industry.

'Healthcare is just one area of the stock market. Within that biotech is one smaller area. It's a speculative area.

'If the research comes to fruition the rewards can be great. At the same time, if they don't reach expectations the effect on the share price can be severe. It's a very high-risk, volatile area to invest in.'

He says that the characteristics of biotech stocks are very like those of technology stocks: 'They react very much like a high growth stock. You are buying in to what the potential rewards could be a long way down the line.

'For me, if investors are going to look that way, I would say get a broad-based healthcare fund which invests in biotech alongside other areas such as pharmaceuticals and medical devices.'

BUYING AN INVESTMENT TRUST: WHAT IS NET ASSET VALUE?

Investment trusts are listed companies with shares that trade on the stock market.

Investment trusts can be riskier than unit trusts/OEICs because their shares can trade at a premium or discount to the value of the assets they hold, known as the net asset value.

NAV is essentially the value of an investment trust's holdings.

It is calculated by dividing the total value of assets (what it owns) minus liabilities (what it owes) by the amount of shares existing.

This is separate to a trust's share price, which is what it would cost an investor to buy in.

An investment trust trading at a discount to NAV may be regarded as cheap because the shares cost less than its overall value - although there might be good reasons why, such as investors being justifiably pessimistic about its prospects.

When a trust trades at a premium to NAV it is more expensive than its net worth.

Investment trusts tend to be a lower-cost option than funds, with no initial charge and lower annual fees. However, buying them incurs share-dealing charges. A good DIY investment platform will cut these.